Good Debt Versus Bad Debt! How do I tell the difference?

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I bet you didn’t know that there are different types of debt! Yes, there is bad debt and good debt.

Continue reading to learn the difference.

Bad Debt!

Many people say that you should stay away from debt at all costs. Contrary to common thinking, all debt is not bad. Yes, there is such a thing as good debt! I define bad debt as loans that are used to purchase your primary home, depreciating assets and consumer debt. A great example of a depreciating asset debt is a car loan. Some great examples of consumer debt are credit cards, student loans, loans to purchase retail goods like TVs, furniture, exercise equipment.
You may be wondering why I have included your primary home mortgage as a bad debt. Any asset that does not return money is not really an asset; it is a liability. This includes your home because you do not earn money from it each month. Instead, it costs you money each month! Your annual property tax, property insurance, wind insurance, and flood insurance bills are all outgoing cash. Add on top of that your mortgage payment and your HOA payment. Now you can see exactly how much money your house is costing you each month. This does not count the hefty down-payment that you put down at purchase. All of this earning you zero return on your investment. Therefore, your house mortgage falls in the category of bad debt!
I know some of you are thinking this guy is nuts! What about all that equity I am building by paying down my mortgage over 30 years. Well, here is the eye opener on equity. It is not guaranteed! What if you need to sell your house the property values are down because the economy is in a downturn? Where did all that equity go? Another thing to consider; what if you have paid the mortgage for 25 years and lose your job? The bank will be happy to foreclose on your house, take it, and sell it for a profit or just enough to get the outstanding balance on the loan. What good is that equity doing for you now? These are just two examples of why your primary home mortgage falls in the bad debt category.

What then is Good Debt?

This is the easy answer! Any loan used to purchase an income producing asset is considered a good debt, as long as you are earning a higher rate of return than the interest rate that the banks are types of debt, , Passive Income IToffering. When I invest in rental properties, I typically make at least 15% cash on cash (CoC) return. To learn about additional real estate metrics, read my four-part post on real estate terms and metrics and take my free cash on cash calculator for a test run. The banks are usually offering less than 4 percent depending on the account type and terms. Therefore, I don’t lose any sleep borrowing money to earn a 15% return on my cash invested.  This doesn’t even take into consideration possible appreciation, debt pay down through monthly payments and the tax advantages of rental properties.
Now that you know the difference between good debt and bad debt, get to work to eliminating your bad debt starting with consumer debt. For more details and to keep you on track, pick up a good book on this subject like Good Debt, Bad Debt: Knowing the Difference Can Save Your Financial Life
Once all your bad debt is gone, save up some cash and go buy an income producing asset using good debt. Good luck!

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